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Behavioral Finance
Behavioral finance is the study of how psychology affects investor behavior and financial markets. The study of behavioral finance relies on the assumption that investors and other financial decision-makers do not always behave rationally and instead often make choices based on cognitive biases or emotional responses; in turn, researchers in the field study how psychological and emotional forces can shape financial markets at scale.
Though the field tends to examine financial decision-making through a market-based lens, some of its lessons can apply to individuals trying to make sense of their own financial decision-making. A related field, financial psychology, looks more closely at the cognitive, social, and emotional factors that affect individuals’ relationships with money.
Traditional economics operates on the assumption that individual actors are always able to practice self-control and make decisions that best promote their own self-interest. Starting in the 1970s, researchers Daniel Kahneman and Amos Tversky—credited with creating the field of behavioral economics—turned that idea on its head, publishing work demonstrating that real-world decisions are often based on limited information, biases and imperfect mental shortcuts (known as heuristics), and heightened emotion.
Researchers in the field of behavioral finance, a subset of behavioral economics, are interested in how these biases and emotional responses affect financial decisions specifically, and how these choices in turn affect broader markets. It accepts that financial decisions are often irrational and may be heavily influenced by individual investors’ mindsets and mental health—for example, research has found that an increase in anxiety reduces investors’ willingness to bear financial risk.
Biases that are of particular interest to behavioral finance researchers include familiarity bias, in which investors are more likely to invest in what is familiar as opposed to what is unfamiliar; loss aversion, in which investors place a higher priority on avoiding loss than they do on making gains; and confirmation bias, in which investors seek out and remember information that confirms their already-held beliefs about a specific investment.
Humans tend to follow the crowd and base their decisions on what others are doing, and financial decisions are not immune from this herd mentality (also called herd behavior or herd instinct). Investors who fall prey to this bias may base their decisions to buy or sell on what they see others doing, rather than what is rational. In extreme cases, herd mentality can lead to stock market crashes or other serious, widespread financial consequences.
Mental accounting, first proposed by economist Richard Thaler, refers to the human tendency to mentally budget our money into different “accounts” and to use them to make financial decisions, even if those decisions are irrational. For example, someone who has gone over their mental budget for groceries may choose to stop buying groceries but continue to spend money on other, less critical “accounts,” like clothing—an irrational choice because the money is being spent either way.
Money plays a significant role in our day-to-day lives, and having money, or lacking it, can have surprising effects on emotions, mental health, and relationships. Just like investors and others whose behavior influences large financial markets, the choices that we as individuals make about money may not be entirely rational: We may spend money impulsively or make frivolous purchases, or we may change our spending habits when upset or anxious—or even when we’re joyful. Insights from both behavioral finance and the related field of financial psychology—which looks at the various factors that influence people’s day-to-day financial decisions—can help us better understand our relationship with money and perhaps spend it more wisely.
Emotions—especially negative ones like fear, anxiety, and insecurity—can trigger irrational or impulsive spending; indeed, advertisers may intentionally trigger these emotions to encourage consumers to buy. Recognizing one’s triggers and developing strategies to respond to them—for example, waiting 24 hours before following through on an impulsive purchase—can help someone control emotional spending and better manage their finances in the long term.
Financial issues can be a significant source of stress in romantic and family relationships. Lacking money can lead to anxiety and shame, which can trigger conflicts or cause people to withdraw from relationships. Disparities in wealth, particularly between siblings or romantic partners, can lead to feelings of inadequacy or guilt. These outcomes are not guaranteed, however, and open communication about money and the emotions that surround it can help couples or families navigate challenges while keeping their relationships strong.
Whether money can really buy happiness has been long debated in the field of psychology. Research does suggest that more money is generally associated with increased happiness—but the relationship is not universal, and some findings suggest that there may be a limit to how much happiness wealth can provide. In general, money itself is likely not the key to happiness; rather, it can be a means to other valuable resources, like time and peace of mind, that do lead to improved well-being.
